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LiquidityUsing Loan-to-Deposit Ratio to Avert Liquidity Risk: A Case of 2008 Liquidity Crisis

LiquidityUsing Loan-to-Deposit Ratio to Avert Liquidity Risk: A Case of 2008 Liquidity Crisis

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Liquidity risk is an on-going issue since the emergence of liquidity crisis of 2008. This paper aims to contribute
to the discussion on how Loan-to-Deposit (LTD) ratio can be used to investigate and avert liquidity problem in
the banking sector. For this purpose, the data of Major British Banking Groups (MBBG) are collected and
critically analysed. The findings of the study reveal that the banks which sustain the LTD ratio were able to
successfully pass through the liquidity crisis of 2008, and other banks which rely more on borrowed funds or
banks with increasing LTD ratio, became the victim of financial crisis.
Liquidity risk is an on-going issue since the emergence of liquidity crisis of 2008. This paper aims to contribute
to the discussion on how Loan-to-Deposit (LTD) ratio can be used to investigate and avert liquidity problem in
the banking sector. For this purpose, the data of Major British Banking Groups (MBBG) are collected and
critically analysed. The findings of the study reveal that the banks which sustain the LTD ratio were able to
successfully pass through the liquidity crisis of 2008, and other banks which rely more on borrowed funds or
banks with increasing LTD ratio, became the victim of financial crisis.

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Published by: Muhammad Sajid Saeed on Mar 01, 2014
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Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.5, No.3, 2014
75
Using Loan-to-Deposit Ratio to Avert Liquidity Risk: A Case of 2008 Liquidity Crisis
Muhammad Sajid Saeed Glasgow Caledonian University, Cowcaddens Rd, Glasgow, Lanarkshire G4 0BA, United Kingdom E-mail: msaeed14@caledonian.ac.uk  
Abstract
Liquidity risk is an on-going issue since the emergence of liquidity crisis of 2008. This paper aims to contribute to the discussion on how Loan-to-Deposit (LTD) ratio can be used to investigate and avert liquidity problem in the banking sector. For this purpose, the data of Major British Banking Groups (MBBG) are collected and critically analysed. The findings of the study reveal that the banks which sustain the LTD ratio were able to successfully pass through the liquidity crisis of 2008, and other banks which rely more on borrowed funds or banks with increasing LTD ratio, became the victim of financial crisis.
Keywords:
Liquidity crisis, Loan-to-Deposit ratio, LTD, solvency, financial crisis, UK banking sector
1. Introduction
The success of any business is largely based upon its liquidity power. Crucial decisions are made in financial market based upon liquidity position. Bhattacharya (2004) defines liquidity as “a firm can maintain liquidity if it holds assets that could be shifted or sold quickly with minimum transaction cost and loss in value” (p. 281). He further added that a firm’s liquidity can be measured by its ability to meet its cash obligations when they are due and to exploit sudden opportunities in the market. Liquidity crisis is a broad term applied to various types of situations where banks lose their huge part of the value suddenly. The liquidity crisis began with the bankruptcy and bailouts of big market giants and spread like a flood & gathered intensity in 2008. In the early 2009, global economy and financial system appeared to be locked in a descending spiral (National Audit Office, 2009). Liquidity crisis mainly emerged in the world’s banking sector in the early 2007 due to the wrong policies of mortgage lenders. According to Caouette
et al.
 (2008) “the liquidity crisis occurs whenever a firm is unable to pay its bills on time or lacks sufficient cash to expand inventory and production or violates some term of an agreement by letting some of its financial ratios exceed limits” (p. 546). The bankruptcy and bailouts of giant companies such as Lehman Brothers, Citigroup, Merrill Lynch, Bear Stearns, AIG, and Freddie Mac have brought difficult time for world’s economy, financial systems, and central banks. The variety and volume of negative financial news have lifted up new questions about the market mechanism and the origins of the financial crisis by which they are propagated. Fisher
et al.
 (2008) believe that the liquidity crisis emerged due to eruption in credit market turmoil. In addition, banks and other financial institutions were failed to absorb liquidity after providing easy access to credit with relatively low interest rates. According to Ackermann (2008), in the beginning of the financial crisis UK monetary policies gave rise to global liquidity which was attached with the exchange rates. In the meanwhile, the subprime mortgage crisis emerged when UK housing market was affected due to lack of mortgage financing. On the other hand, the refinancing of off-balance sheet vehicles put more pressure on bank’s liquidity (Gibson, 2008). The literature evidence reveals that the impacts of liquidity risk on the profitability of bank is of mixed nature. According to some experts (e.g. Molyneux and Thornton, 1992; Barth
et al
. 2003) liquidity risk has a positive impact on profitability of banks. On the other hand, Kosmidou
et al.
 (2005) believe that it has a negative impact. In reality, no detailed work has been carried out on liquidity and its impact on banking operation.
2. Literature review
2.1 Importance of liquidity for banks
Traditionally, it is believed that banks exist to create liquidity from illiquid assets and it is also known that bank’s success or failure is based on liquidity risks (Diamond and Dybvig, 1983). Besides, the study of liquidity risk is important for the banks in terms of determining their profitability or interest margins (Kosmidou
et al.
 2005). In the past, experts mainly focused on measuring credit and operational risks and often ignored liquidity risk measures. However, it is clear from the recent financial crisis that liquidity risk is an important issue in
 
Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.5, No.3, 2014
76 terms of customer deposits, customer loans, wholesale and funding products, and technological advancements (Controller and Auditors General, 2010). Liquidity risk became more relevant to banks due to two major factors in funding. According to some experts (e.g. Blaschke, 2001; Padmalatha, 2011) the first factor of importance is the increase in utilisation of credit sensitive wholesale funds. On the other hand, other practitioners believe that the growth of off-balance sheet activity is the most significant factor for the banks to be managed in order to avoid liquidity risk (Ackermann, 2008). The literature investigation shows several impacts of liquidity risk on the profitability of the banks. The liquidity is positively correlated with the market value of the bank, if the bank is earning higher profits and is also able to access sufficient funds to meet payment obligations in a timely manner (Barth
et al.
 2003). On the other hand, the liquidity is negatively associated with the market value of the bank and a bank gaining losses refer to its inability to access sufficient funds to meet payment obligations in a timely manner (Kosmidou
et al.
 2005).
2.2 Sources of liquidity risk in banking sector
A fundamental source of funding in the banking sector of the UK is saving accounts. The customer deposits normally signify the steady and low-cost approach of funding. In the late 1980s, investment and saving vehicles were available to bank customers that create difficulties for the banks to retain core deposits. The fast growth of the banking sector and an extensive reliance on market funding sources expose banks to the price and credit sensitivities of major funds providers (National Audit Office, 2009). In order to fulfil the funding requirements, banks implemented off-balance sheet strategies such as asset securitisation. Once these activities of the banking sector were increased, the liquidity risk emerged in the banking industry. In particular to liquidity risk, there are many sources from where liquidity risk emerged in the banking sector of the UK. According to Koch and MacDonald (2008), asset side and liability side are the two fundamental sources of liquidity risk where asset side deals with the degree of inability of banks to convert its assets into cash and also caused by loan commitments and other credit lines such as either by borrowing funds or by running down cash reserves (Gibson, 2008). In the UK economy, loan commitments for vehicles and commercial paper conduits have led to significant growth in bank assets requiring funds and when liquidity dried up the banks sold investment securities at the price of an asset that is less than the normal price in the market. On the other hand, liability side originated from the unexpected recall of deposits when banks borrowed short term loans and lend long term finance. Therefore, they put themselves at liquidity risk. It happened just like if an individual or an organisation has £200 million in the demand account and instantly they claim money back. In this case, the bank has to return the money to the depositor but on the other hand, the bank is receiving insufficient additional deposits and cash inflows and consequently, the liability side of a bank’s balance sheet is contracting (Saunders and Cornett, 2008). Mullineux and Murinde (2003) identified few more sources of emergence of liquidity risk in the banking sector on the basis of bank’s behaviour and misjudgement towards cash inflows and outflows. He further explained that banks can control the timing of the cash flows but today, they are more concerned with supplying credits and liquidity services to individuals and organisations that have their funding sources in other capital markets. According to Ismal (2009) liquidity risk emerged in the UK banking system due to risk activation by secondary sources such as failure of strategy, corporate governance, and mergers and acquisitions. The fall of ‘General American’ is the best example in this case when its investors withdrew their funds due to company’s weak long-term strategies and corporate governance issues. In order to handle the situation caused by the financial crisis, central banks introduced an extensive amount of liquidity into the financial market. This strategy works for the short time to stabilise markets but after some period banks bear more unexpected losses due to currency mismatch on balance sheets especially when EU banks increased dollar funding (Ackermann, 2008).
3. Research Design and Methodology
This research follows the exploratory research design due to its logical use of qualitative approach. This study is a non-experimental based research which strongly addresses the need to investigate an unexplored area such as ‘how liquidity crises of 2008 emerged into the UK banking sector’. The study neither assumes any hypothesis nor employs a large amount of data. The major aim of this research is to understand the concept of liquidity and

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